What Do Entrepreneurs Need to Know about Convertible Notes?

Entrepreneurs now have more opportunities for financing, especially at the seed level, than ever before. Angel investors, venture capital funds, and other investors all want to get in at the ground level. For this reason, entrepreneurs need to know more about equity issues. Convertible notes, in particular, have become especially prominent in Silicon Valley and other entrepreneurial hubs across the country.

In the most basic sense, a convertible note is a short-term debt that becomes equity. For startups, a convertible note typically becomes preferred stock once the Series A financing round closes. For investors, convertible notes mean making an investment in return for preferred stock rather than repayment with interest.

Why Are Convertible Notes Necessary?

Startups can issue shares of common stocks to investors, and they do so regularly. Incubators typically receive common stock, and small investments from friends and family may be repaid in common stock. Sophisticated investors, however, will push instead for preferred stock, which comes with certain rights. Convertible notes are also beneficial to founders because issuing common stock risks dilution depending on the valuation of the startup.

Also, tax issues can cause complications. If cofounders issue themselves common stock for a nominal price but charge much higher prices to investors, the IRS can value the cofounders’ shares higher and tax the difference as income. Common stock at the seed stage can also result in a high strike price, which limits wealth generation. Founders want to set the strike price low to incentivize people to buy, which causes the value of the company to rise.

By issuing convertible notes, founders can push the issue of valuation to the Series A financing round, when many more data points will exist and the number can be more accurate. Thus, founders can avoid all three of the above problems. Because a convertible note is a loan, and thus a debt rather than equity, no valuation is necessary at time of issuance. Without valuation, founders do not have to worry about dilution, taxes, or setting prices for options.

For what other Reasons Would Companies Issue Convertible Notes?

Convertible notes have a number of other benefits. The three primary benefits are fast speed of issuance, simplicity of paperwork, and low associated costs. Startups can close a convertible note round in as little as one day with very short promissory notes that each cost about $1,500 or $2,000 in legal fees. Note purchase agreements, which are also customary, will slightly increase legal fees, but they still do not compare to the $10,000 to $10,000 required for the issuance of preferred stock. Also, preferred stock term negotiation often requires weeks.

Founders often prefer convertible notes because they do not give any control to investors. At the point when investors receive preferred stock, they typically have certain and often significant control rights, such as board seats and veto rights included in “protective provisions.” For example, preferred stock holders often have the right to veto the sale of a company. On the other hand, convertible note holders only rarely have any real power, and they receive no minority stockholder rights. According to a 2011 survey, only 4 percent of convertible note holders received board seats, compared to 70 percent of preferred stock holders.

Do Convertible Notes Have Consequences for Prospective Investors?

One of the most overlooked benefits of convertible notes is the flexibility provided in terms of raising further rounds of investments and attracting potential investors. In short, convertible notes provide a mechanism for variable pricing. Convertible notes come with a conversion valuation cap, which protects investors by limiting the conversion price of the note so that investors can share in any increase in value of the startup after the investment. For example, a startup may place the cap at $5 million and then receive a valuation of $10 million in the Series A round. The note would convert into shares of preferred stock at the price of $5 million, which is half the price paid by Series A investors.

The cap is similar to a valuation in the priced round, but it does not count as an official valuation for tax purposes. Thus, investors may get different caps, which is not possible in a priced round unless closings are far enough apart to justify the different valuations. Founders can take advantage of this fact, and the cheap and easy nature of convertible notes, to complete high-resolution funding, meaning that they have a separate note with different caps for each investor. Caps are important because the interests of founders and investors are in conflict if convertible notes do not have them. Investors are penalized for trying to get a higher valuation for the startup because it is in their best interest to have a minimal valuation.

How Willing Are Investors to Accept Convertible Notes?

The most sophisticated investors tend to push for shares of preferred stock rather than convertible notes because preferred stock generally comes with control rights like a board seat. People with preferred stock may also have economic rights similar to those of Series A investors, including pro-rata rights and liquidation preference. For this reason, some investors may push for “Series Seed” and similar standardized forms that make a priced round fast and cheap, similar to issuing convertible notes. Ultimately, convertible notes do not start earning capital gains until conversion, but preferred stock starts the earnings immediately.